Dovish Fed pivot to keep rates low

12 aprile 2019

Salman Ahmed, PhD

Chief Investment Strategist

Charles St-Arnaud

Senior Investment Strategist

Jamie Salt

Analyst

Global risk premia normalised in the first quarter of the year amid a remarkable change in tone from the US Federal Reserve. The central bank has changed its stance significantly, presaging what we believe will be a move towards some form of price-level targeting and cementing the case for a low real and nominal interest rate environment. The change should divert previous headwinds for emerging market (EM) assets.

The sharp pivot in Q1 reflects the Fed embarking on a once-in-a-generation review of its monetary policy framework, we believe. The U-turn was most clearly highlighted by the shift lower in dot plots for 2019: the Fed went from forecasting three rate rises (at its meeting in December 2018), to predicting zero increases (at the March 2019 meeting). This veritable collapse in tightening expectations transpired over a span of just 12 weeks as the Fed shifted towards a more patient stance on removing accommodation. It also led to the widespread perception of hawkish rhetoric at the December meeting representing a ‘communication mistake.’

We believe that generating above-target inflation is becoming a policy goal as the Fed recognises that the neutral real rate has likely fallen and is set to remain below the average seen before the 2008 financial crisis. Recent talk of price-level targeting is one avenue through which such a meaningful shift of the reaction function could occur. More clarity in this regard is likely in coming months, in our view.

We believe that generating above-target inflation is becoming a policy goal as the Fed recognises that the neutral real rate has likely fallen and is set to remain below average...

This shift in the Fed’s reaction function implies that for a given level of macro conditions, US monetary policy is likely to remain easier than what would otherwise be implied by its dual mandate. That mandate specifies the Fed must effectively promote the goals of maximum employment and stable prices.

Such a change in Fed reaction function - combined with sluggish global growth and an accommodative stance from the European Central Bank – cement the case for rates remaining low-for-longer, even if inflationary dynamics surface, particularly in the US.

US nominal rates are likely to remain between 2.6% and 2.3% for the rest of the year, in our view. We continue to expect a low probability of a US-driven recession, and believe that the inversion of the US Treasury yield curve reflects Fed policy actions since 2008 rather than predicting a recession. If anything, we believe the sizeable easing of financial conditions engineered by the Fed is likely to extend the business cycle.

Positive environment for EM assets

Significant headwinds for emerging markets arose last year from idiosyncratic risks and US policy tightening, particularly for countries with external vulnerabilities. Now, the Fed’s pivot substantially reduces pressure on emerging market central banks to tighten domestic policy in 2019.

As such, we expect no major EM central bank to hike over the next 12 months. This backdrop, together with encouraging signs in Chinese indicators, should be positive for EM asset performance this year, leading us to maintain our pro-risk stance.

We are, however, somewhat perplexed by the resilience of the dollar against EM currencies. While dollar strength against the euro is a consequence of potential ECB easing, the argument does not apply to emerging markets. Here, we also note the stability in CNY is becoming more critical for broader EM foreign exchange dynamics relative to the DXY (US dollar index), as the operating framework of CNY is subject to review whilst a US-China trade deal is negotiated.

Overall, we think that the environment has turned positive for EM assets and we believe that US dollar resilience will give way to gradual EM currency appreciation in coming months.